Principles of Internal Controls & Corporate Governance

Business Ethics

The sum of principles and code of conduct that

businesspeople must adhere to in their dealings with
stakeholders

Unethical issues in Business

Poor labor practices e.g.
1. Nepotism
2. Tribalism
3. Overworking employees
4. Selling of substandard products.
5. Low wage rates.

Why business ethics?

1. Sensational corporate scandals.

2. Fraudulent activities
3. Doubt in business people.
4. Poor labor practices.
5. Failure of corporate.
Principles of Business Ethics

1. Trust
2. Excellence
3. Responsibility
4. Customer focus
5. Accountability
6. Focus on the people.

The Role of Ethics in Businesses

1. Protection of own reputation and interest.

2. Meet stakeholders’ expectation.
3. Prevent harm to the general public.
4. Protect organization from abuse by unethical
employees & competitors.
5. Protect the rights of their employees.
6. Attract customers thus boosting their profits
7. Reduce labor turnover thus increasing productivity.
8. Attract skilled person ell thus reduces recruit cost
9. Keeps the company's share price high thus boosting
 investor’s equity

Unethical issues in business.

An ethical problem is the decision made after weighing

fraudulent benefits to what he considers moral and
appropriate.

1. Conflict of interest i.e. the CEO must choose whether to

benefit himself or maximize the shareholders wealth
anger
2. Fairness and honesty.
3. Communications.
4. Business Relationships Keeping company's secrets being
responsible.
5. Plagiarism. Presenting someone else’s research findings
as your own work.

Improving Ethical behavior in Business.

1. Develop a code of ethics.

2. Consistent leadership
 3. Ethical training programs.
4. Rewards
5. Open climate
6. Controls
7. Ethical ombudsman
8. Ethics committee.
9. Hotlines

Internal controls

Policies and procedures adopted by the management to assist

in the achieving of business objectives. These include:

1. Orderly & efficient conduct of businesses.

2. Safeguarding assets
3. The accuracy of accounting records.
4. Timely preparation of accounting information.
5. Establishing parameters to delegate power
6. Testing and reporting compliance on the established
parameters.
7. Evaluation of operational effectiveness & efficiency
8. Assessing reliability of financial reporting
 9. Reporting compliance on the established rules and
regulations.
10. Supporting remediation efforts by examining limits
of power.

Distinction between Internal controls and internal audit

Internal controls
Are interested in validating operational and financial
processes used in the cycle with a purpose of exposing
weaknesses and identify major areas of improvement

Internal audit
Are interested in validating data and reports at the end of
the business cycle for purposes rendering judgment &
opinion

Internal control framework

It is composed of:
 1. Control Environment. Establishes the overall tone of the
organization.

2. Risk assessment. Identifies and analyzes relevant risks

and how they can be managed

3. Control activities. Policies and procedures designed to

mitigate risks and achieve internal control objectives.

4. Information & communication.

A system that identifies, captures& communicates
upstream and downstream information/data

5. Monitoring, evaluating and reporting.

Regular monitoring occurs at all level of management to
show effectiveness of internal controls.

Dangers of weak internal controls

1. Business interruptions from catastrophes.
2. Erroneous management decisions.
3. Frauds, theft embezzlement of funds.
4. Statutory sanctions due to non compliance.
 5. Excessive costs leading to fund deficits.

6. Misuse & loss of inventories and assets.

Benefits of internal controls

1. Clear chain of authority
2. Provides a system for identifying, analyzing and
mitigating risks.
3. In-house dissemination of reliable information.
4. Control activities proportionate to the implication of
each individual process

Indicators of a broken internal control process

1. Inadequate management oversight and accountability.
2. Inadequate control of activities and performance.
3. Inadequate assessment of risks.
4. Inadequate communication.
5. Ineffective and inadequate ways if monitoring activities.
Key internal control
1. Separation of duties.
2. Documentation
 3. Authorization and approval.
4. Security of assets.
5. Reconciliation and reviews.
6. Employee training.
7. Formalized policies and procedures.
Internal control players
Those who design and monitor operational efficiency of
internal controls.
1. Board of Directors
2. Executive Management
3. Internal Audit
4. Company staff

Limitations of internal controls

1. Cannot turn a poor manager to a good one.

2. Imperfect thus risks and errors are bound to occur.
3. Susceptible to management override
4. Only designed to cope up with routine transactions.
5. Resource constraints.
Corporate Governance
Definition;
 The system of checks and balances both internal and
external that ensures accountability and social
responsibility

Common failures in Governance process

1. Failure of the Board and executive management

2. Failure of internal controls
3. Failure of external controls
Failure of the Board & Executive management

a) Ineffective boards
b) Conflicted CEO's
c) Breach of duties of care and loyalty.
d) Entrenched management.
e) Failed corporate policies.

e) Failure in corporate policies.

It entails;
 1. Disregard to corporate policies.
2. Skewed compensation skills
3. Unclear strategies
4. Miss allocation of resources
5. Excessive short term focus
6. Opaque disclosure
7. Unethical behavior

Failure of internal controls

1. Lack of technically qualified and independent internal
controls
2. Liberal accounting policies
3. Excessive risk taking
4. Inadequate audits

Failure of external controls

1. Inadequate regulatory mechanism
2. Insufficient legal/bankruptcy regimes
3. Lack of block holder/ activist monitoring.
4. Weak/undeveloped capital markets
5. Unacceptable external audits
Inadequate regulatory mechanisms
 Inadequate tax oversight.
 Moral hazard
 Restrictive or liberal ownership rule.
 Competitive barriers
 Unclear monetary policies
 Supervisory conflicts of interest.
 Inadequate regulatory disclosures.

Corporate Governance
Refers to the manner in which power is exercised in
corporation`s total portfolio of assets and resources with a
view to creating, maintaining and increasing shareholder
value.

Causes of Governance Failure

1. Weak boards which can be cajoled by powerful

executives
2. Lack of expertise by the executives
 3. Inattentive directors who derive gains from ties with
executives
4. Ineffective internal auditors that cannot detect and
prevent problems
5. Poor external controls, regulators and auditors, capital
markets and legal frameworks to give proper regulations

Basic Corporate Structure

Most body corporates i.e. derive their capital from debts and
equity.
The people who provide the funds enjoy certain rights and
benefit.
Some of these benefits include:
Ownership/claim on the company`s assets.
Periodic payment of Dividends etc
Legal rights/entitlement as explained
below.

Legal rights entitled to providers of equity

They can transfer shares through the securities exchange to
other investors.
They are entitled to regular and accurate disclosures of the
company`s financial statements.
They can participate in the Annual General Meetings (AGM)
and make decisions e.g. on the selection of the BOD,
corporate reorganization and acquisitions.
The company is only liable up to the amount of equity
invested thus in the case of insolvency, the creditors/ debt
providers cannot look up to shareholders for additional
capital.
The debt providers offer funds to limited liability companies in
return of periodic interest payments along with the principal
amount they lent out.
NB: Incase the company incurs losses the creditors are
given the first priority during compensation the remainder
of profits from the sale/liquidation/realization of assets is
shared out among the equity providers.

The Agency Problem

With respect to LLCs, companies have owners known as
shareholders or stockholders. They own shares of the
company which are symbolized by stock certificates.
Public Limited Companies are those which are registered at
the Securities exchange market thus their shares trade
publicly.
Since the shareholders may be so many, they cannot run the
company, thus they approach some other people to oversee
its operations i.e. they appoint the BoD. Thus the BoD become
representatives (agents) of shareholders (principals)
The BoD may lack the expertise to run the business thus
approach other people known as Executives headed by the
CEO/President to run the business. When the BoD colludes
with the executives to draw undue benefits from the
company, an agency problem arises.

The Executives are given powers to make decisions which are

geared towards maximizing shareholders` wealth. They are
also charged with the responsibility of implementing BoD
decisions. The executives having considerable control over
the business may decide to act for their own benefit and
malign the BoD and indirectly, the shareholders, an agency
problem comes up.
Since the shareholders know the BoD is bound to err, they put
up measures to reduce risks by incurring agency costs e.g.
hiring external auditors, tax assessors and lawyers.

Forms of Ownership and Control

Total/Complete control: i.e. family owned business Example
the Brookside Dairies is owned by Kenyatta family.
Majority control: enables the largest shareholder have
effective control of the business e.g. in amending the
corporate charter.
Legal mechanisms control. Occurs when legal mechanisms
permit effective control without majority holder’s stake

Non-voting stock holder control/ preference shareholder

control: these have control over the issuance of dividends.
They get the first priority during issuance of dividends but lack
legal voting rights.
Voting trust control: comes about when the shares are held by
a trustee. The trustee cannot vote since he holds the shares
fro another individual.
Minority control: can only work if a large block holder does
not exist.
Management control: occurs where the management appears
to be the controller of activities.